I lead a multi-family office and trust administration firm, having earned a doctoral degree in finance, a law degree and an advanced degree in taxation. I have over 20 years of experience in all aspects of managing and administering the business and investment interests of families--including domestic and international tax and estate planning, as well as business transition planning.

How The Wealthiest Families Make And Lose Their Money -- Part 4

In Part I of this series of articles on wealth creation and maintenance, we discussed that the 70% of wealthiest families obtain their assets from business ownership by the current generation and only 5% derives from inheritance. One expert who advises wealthy families cites the dividing of family assets in subsequent generations is the greatest destroyer of family wealth. In the second installment of this series, we touched upon the subject of professional management. While mom and dad had the business acumen and financial discipline to build a business, those traits are not necessarily hereditary. Successful families retain professional management. In the third installment of this series, we illustrated some of the challenges professional management faces. We will now delve into where professional management can add value.

Studies over the years have repeatedly found that asset allocation drives 90 to 95 percent of risk and returns in a portfolio. In essence, what kind of pie chart a family’s portfolio has will be the greatest determinant. This would suggest that professional management’s time is perhaps best spent identifying the asset allocation that will best meet a family’s needs as opposed to market timing or stock-picking. And, historically, broad diversification across many asset classes – such as that found in the Endowment Model – has delivered a superior risk-return profile than that of traditional allocation models, which are more narrowly diversified.

Additionally, when it comes to management of publicly traded securities, the Standard & Poor’s Indices Versus Active Funds (SPIVA®) Scorecard has repeatedly found that, over the long run, active managers tend to underperform their respective index benchmarks. In the end-of-year 2013 SPIVA® Scorecard, of all domestic large-capitalization equity mutual funds that were in operation for five full years ending 12/31/2013, nearly 73% underperformed the S&P 500 during that period. During the same period, nearly 71% of international equity mutual funds underperformed Standard & Poor’s international equity index. As for real estate investment trusts, over 80% of REIT mutual funds underperformed the S&P U.S. REIT Index. SPIVA® Scorecard data would suggest that professional management’s time is best spent indexing those allocations to the publicly traded markets rather than trying to find the fund manager who can consistently “hit it out of the park.”

The National Association of College and University Business Officers (NACUBO), among other things, tracks several hundred school endowments across the country. It monitors asset allocation, performance, and distribution rates. NACUBO’s annual study of endowments has consistently found that the Endowment Model’s broadly diversified asset allocation outperforms and provides a more consistent distribution rate than the traditional asset allocations over a 10-year period. A key finding is that the superior performance and more consistent distribution rate is associated with a lower allocation to publicly traded securities and a higher allocation to “alternative” and privately held investments.

This appears to be sentiment of David Swensen of Yale University’s endowment: index the public markets and actively manage in the private markets. The publicly traded securities markets are “efficient.” There are thousands of eyes – if not millions – watching Microsoft and General Electric and Pfizer. What is it that the one market participant sees that the other market participants don’t? This means that it is very difficult for one market participant to obtain a performance advantage over other market participants . . . at least across many stocks and on a sustained basis. So, don’t expect outperformance in the public markets. If this is the case, one should save oneself the time and effort and simply index.

On the other hand, the private markets are not efficient. Such investments might include directly held private companies, real estate, oil/natural gas wells, timber, or agriculture. For any single investment, far fewer eyes are watching if many at all. Information about a particular office building in Indiana or timberland in Idaho or a walnut farm in California might only be known by a handful of potential investors. It is this disparity of information that gives birth to inefficiency and opportunity. It will be in these inefficient private markets that families will want to actively participate.

At the end of the day, professional management’s primary value-add to a family is intellectual honesty. Where can money be made and where can’t money be made? Where should the family be taking its risks and where not? And, given the answers to those questions, sticking to the discipline.

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